By Frances Nagy, Managing Partner, West River Partners
Entrepreneurship is synonymous with names such as Bill Gates, Ray Kroc and Sam Walton. It is innovation and creativity, risk-taking and the process of building sustainable companies that fill a market void. However, in the investment field, it is also an overlooked asset class that may well deserve investor attention.
As the search goes on for viable and profitable alternatives to traditional assets, now may be the right time for investors to explore emerging manager alternative funds and invest in entrepreneurship.
Emerging managers in the alternative asset sector, such as private equity and hedge funds, are primarily defined as either recently started funds or those that manage less than $500 million in assets.
A Look at Returns
A Pertrac Financial Solutions study reported on 2007 returns, and confirmed for 2008 returns, that both small (under $100 million) and young (under two years) funds outperformed larger (over $500 million) and established (over four years) funds. Pertrac’s most recent study found that the small and young, even accounting for a dismal 2008 and taking into account survival bias, trailed the returns of the large and established group for the full year of 2008. However, over a 13 year period, the small and young group outperformed their more established peers by over three hundred basis points on an annualized basis.
The Pertrac study does not directly address why these results differ so much. One possible explanation: the difference may be due to smaller funds putting smaller amounts of money per transaction to work in less covered and, as a result, inefficient markets. It certainly would make sense, as smaller investment “bite sizes” would likely be too small to “move the needle” at larger alternative institutions and fall below the larger funds’ minimum investment size.
Emerging Manager Investment Strategies
Strategies in the emerging manager space are the same as those employed by more institutional funds except they are likely to be more specialized and generally run by a younger crop of managers who believe they have a better way to achieve superior returns. Some examples would be a distressed loan fund which would be a subset of a large distressed credit fund at a bigger firm or a long-short hedge fund that focuses entirely on U.S. retail-related stocks as opposed to a long-short fund that has a mandate for all U.S. stocks.
In addition to the research that shows smaller investment funds can achieve greater returns, industry-wide distress has expanded opportunities for the smaller funds. For example:
1) Large, existing funds are actively exiting what they consider to be “non-core” strategies, regardless of their profitability. Have you heard a hedge fund manager speak about “returning to his roots”? The flip side to this decision is that investment teams have been let go that have viable investment strategies.
2) Successful teams are leaving stressed firms on their own accord either to start up new funds or to seek better economics from healthier funds. If faith is lost in the viability of a large fund, both investment teams and individuals seek greener pastures.
3) Funds that have been on the sidelines are now actively investing. Those who were hesitant to invest in an uncertain environment or who had not seen much investable activity now see opportunity outstripping investable capital. This is generally true for those with distressed, credit or otherwise illiquid strategies as these funds start to see deal flow again.
The largest allocators of capital are also exploring investment opportunities in new funds. CalPERS and Illinois Teachers, for instance, have mandates to invest hundreds of millions of dollars with emerging managers, and several financial institutions, such as Investcorp and J.P. Morgan, have seeding programs that invest similar amounts in the general partnerships of start-up groups.
It would appear that professional allocators with the widest mandates (including consultants, independent private wealth managers, and large family offices) would be looking to take on smart, new firms that have the right skills to take advantage of opportunities in this environment.
It would also appear that allocators would invest in start-up funds as a form of portfolio diversification by adding a hungrier, niche fund to balance out its roster of more institutionalized funds.
Instead many allocators are either not allocating at all or are sticking with “funds we already know.” This may be a huge opportunity for the independent-minded investor. One astute investor Wes Edens, used to say that he spent a lot of time thinking about what will be the obvious elephant in the room in the next five years that is not visible now.
Evaluating Emerging Manager Funds
What’s a viable method of evaluating an emerging manager fund? Look for two basic pieces of information:
1) If it is an alternative strategy, positive returns in 2008. Many funds were down in 2008, but 30% of hedge funds, as determined by Hedge Fund Research in Chicago, IL, were up in 2008. Investment consultants prefer to work with those who did a great job in a very tough environment and are by definition above average.
2) A verifiable track record of investing in the current asset class for 5 years. Some emerging managers may not have been on their own for 5 years, but they “own” their track record at a previous fund i.e. a previous fund will sign off on those returns. In addition, try to avoid a manager who is testing out a new strategy or diverging from a previous specialty.
Investors who are interested in investing in the emerging manager space should be in touch with the following:
- Capital introduction groups: When a new or small fund is looking to raise capital, it can either hire someone in-house or it can outsource its capital raising function to these groups. During this time of constrained capital, many emerging managers seek the help of professional third party marketers to better align cash in and cash out.
- Investment clubs: For-profit and non-profit groups made up of high net worth investors band together to hear investment pitches from funds and other investment opportunities.
- Conferences focusing on emerging managers: For-profit and non-profit organizations put on annual conferences that focus exclusively on emerging managers.
- Fund of funds managers: Many funds with a focus on emerging managers perform the selection and due diligence process on behalf of individual and institutional investors.
- Financial advisors who have a practice of selecting funds: Many open-architecture, wealth management firms already offer several private equity and hedge funds to their clients, and they may be looking at new funds to add to their platform.
Every investor worries about making a bad investment. It is often said that large allocators of capital primarily invest in large institutional groups because “no one ever got fired from investing in KKR.” Investors need to know their own risk tolerance, and obviously there is no guarantee that a manager’s past success will be duplicated.
For those who want exposure to the space, but want to limit exposure to a single manager can approach allocation a few different ways:
1) Make an initial, small investment followed by a larger investment after performance achieves expectations or
2) Invest alongside a manager on a deal-by-deal basis through co-investments.
A Final Thought
It is hard to predict what today’s elephant in the room will be when looking back in five years, but surely some of the new funds in today’s challenging environment will become the next important managers of tomorrow. It is worthwhile recalling that all household-name companies, like Microsoft, McDonald’s and Wal-Mart, as well as institutional alternative investment funds, like Carlyle and Soros, were once start-ups.
